03 June 2018

With much of the action being dictated from outside of Japan we keep a very close eye on events overseas. US stock markets seem to have calmed again as we go through another relief rally but this time, coming a full circle back into FANG names. Interestingly, some explain that the group is now being seen more as a defensive play as higher input costs and America's growing trade dispute with the rest of the world have left many industrials with a more uncertain earnings outlook and made them more prone to political risks.

Just how long this US market's disconnect in direction of techs to other cyclical stocks can last remains to be seen but as far as social media names are concerned, clearly there is less risks there. However, we remain highly cautious on most Japanese hardware-centric technology stocks which are trading close to their historical highs. Annual semiconductor capex is also at multi-year highs, with most bullish expectations looking priced into their relative rich valuations.

With memory pricing likely to weaken further as more capacity and better production yields come into effect, we think much of the coming bit growth will be offset by this likely deteriorating pricing environment. With government-backed Chinese tech firms having been aggressively pouring funds into expanding their footprints in displays and semiconductors as a directive by China's policy makers, medium-term pricing trends are not encouraging with the LCD market one of the very first sub-segments which already looks to be facing its own recession.

With fall in activity in crypto currency mining hurting the very high-end computing demand, growth in data centre outlays starting to become more patchy while global smart device market is increasingly saturated, we think surprises in the semiconductor market look to be on the downside for now. We thus remain generally negative on most semiconductor-related plays with Japan's flat panel and semiconductor manufacturing equipment plays having remained one of our core focus areas of finding short picks.

Moving on to recent events in Europe, although concerns about the fate of Euro seems to have subsided for now, the political situation in Italy remains very fluid as populists fiscal policies leave major question marks regarding its future in the EU. Also, last week's change in the Spanish government triggered by a victory of no-confidence motion led by the Socialists but supported by Catalan and Basque separatists also raised chances of more debate about their regional independence and potential break-up of Spain--although here all parties remain pro-EU.

Going back to the eventful US politics, the coming North Korean peace talks seem more of a distraction to ongoing concerns about a trade war which is far more consequential for capital markets. Moreover, the growing rift between the US and its trading partners and allies for unilaterally raising sanctions on Iran has added more tensions already simmering about the US role in NATO and EU's growing defiance in charting its own course in defence and trade policies.

If this multi-generational geopolitical shift was not enough to grapple with, we are also going through the motions of a major monetary policy regime change, from ultra-loose to a 'normalisation' mode which given the sheer scale of leverage built up by governments and corporations it is bound to squeeze dollar-based debtors. This suggests some emerging market currencies will remain under pressure as focus shifts away from Euro and back to US rates and the dollar.

With almost all US indicators pointing to higher pricing environment and full employment which looks to be starting to feed through in better wages, we see Fed raising rates much higher from here and we would not be surprised to see US ten-year yields well above 4% within the next 12 months.

Another key concern remains the fast flattening shape of the US yield curve. With Fed most likely to raise rates on June 13th, investors will keep a close eye on the gap between two-year and 10 year which shrunk to less than 50bps last week, lowest since 2007 and just before the financial crisis engulfed the markets.

Back in Japan, we have seen signs of BOJ slightly tapering its QE program at the very long-end. Interestingly, this taper seems to be forced upon it given the increasingly illiquid state of the JGB market, where there is a big waive of maturities coming and there simply isn't enough paper for BOJ to buy.

Given Japan's extremely tight labour market, exposed by its recent economic growth, the rising input costs being seen across the industry and healthy capital investment trends, we think BOJ needs to taper much more aggressively and sooner than what it is guiding for currently. We think this could exert more pressure on the yen to strengthen and keep the stock market in check while we expect Japan's undervalued financial stocks to out-perform.

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